Can We Avoid Another Cataclysmic Meltdown Of The Global Financial System?

December 15, 2016

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by Tim Sklar (Sklar and Associates/Biofuels Digest) Take-aways from Rana Foroohar’s Article Titled “Saving Capitalism” (Time Magazine, May 23, 2016) and her book titled ”Makers and Takers, The Rise of Finance and the Fall of American Business”.

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Although we still believe that there will be a place in our energy future for bioenergy and biofuels, we believe that the future outlook for bioenergy and biofuels development will remain uncertain, as the future of the US and the global economy has not fully recovered and the prospects for another financial melt-down and subsequent recession, remains as a distinct possibility.

Some experts are now suggesting that the U.S. system of market capitalism itself is so broken that another cataclysmic collapse is imminent. We are equally concerned that the fixes that are described by these experts, may not be effective any time soon. And one has to wonder whether there is the collective will to accept the “strong medicine” we are being told is needed.

In her new book, titled “Makers and Takers…” and her recent article that appeared in Time Magazine, Rana Foroohar has provided excellent and lucid explanations as to how we got into the fix we are in over the last 40 years. She also describes some of the “strong medicine” that may be needed. She clearly places blame on what has happened to our financial system and describes how our financial banks, hedgefunds, mutual funds, insurance firms, and trading houses are no longer providing financing to the real economy. She admonishes those who own and manage our financial institutions for being so self-serving that they are no longer a help to business. She concludes that our financial institutions have now become a hinderance to business and are no longer serving the real economy or society as a whole. Unfortunately, she devotes only one 10-page chapter out of eleven of her book to the discussion of five big ideas that would integrate finance into the real economy, to better serve our shared prosperity and growth.

... this synopsis is offered. It highlights each of her chapters in “Makers and Takers”, and culls out the various “fixes” that are mentioned. I then opine on what has to happen to implement each “fix”. This should help the reader decide for themselves, whether obtaining such a fix is probable or problematic.

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What’s Changed? Increased Financialization

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She notes that our financial institutions were initially designed to provide financing to businesses and consumers.

But due to increased “financialization”, these financial institutions have shifted away from financing the real economy and are increasingly using “financialization” as their primary way for creating wealth.

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She claims that these practices have been so lucrative as to deprived businesses that operate in the real economy that actually make things, of the funding they need to recover and to grow.

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“Movers and Takers” presents four major findings.

1) The capital markets and the banking sector in particular, are providing less funding for new investments as most of the money in the system is being used in lending against existing assets. And the financial industry’s focus has changed from lending to speculation.

2) Financial institutions are increasingly behaving less like banks and more like casinos. These institutions are using a variety financialization schemes to boost their share prices through investing and trading securities for their own account in order to run up the value of their stocks through stock buy-backs.

3) Financial institutions have also used these financialization strategies to create wealth for their CEOs and other officers thought offering stock options as bonuses, then buying back these awarded shares at inflated values.

4) Many American corporations other than the financial institutions, have embraced comprehensive financialization strategies. Some of them have decided not to re-invest in growing their core businesses, but to divert their sources of financing away from business growth activities and market expansions to serve consumers in the real economy. Instead they have been using their investment capital to acquire and trade assets in order to inflate asset values and increase their stockholders’ share value.

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Chapter 11 Refocusing Finance-Servicing Both Business and Society

This most important but very short (12-page) chapter contains Ms. Foroohar’s prescriptions “how to put finance back in service to business and society”. It is organized under five topic headings. Each topic lists a mix of specific “fixes” and more often than not, only general solutions are offered. These “fixes” are briefly discussed. The most relevant ones include comments made with respect to those of us who are still trying to develop viable projects the real economy.

Changing Our System of Market Capitalism

Market capitalism as we know it has evolved over decades, creating a finance system that has hindered, rather than helped business and society. There seems to be general agreement that a set of rules that govern our financial system ought to be made to foster more equitable wealth distribution and to stimulate economic growth. And specific rule changes are now needed to better regulate finance, fix corporate governance and revise our tax system. Wisely, Ms. Foroohar believes that before any of her prescriptions and reforms that she has identified are made, they ought to hashed out among a broad group of stakeholders, not just shareholders

Comments: This implies economic growth and increases in asset values are not the same thing.

Ending Complexity and Cutting Leverage

Ms. Foroohar believes that most To-Big-To-Fail financial institutions, are too complex to manage. She argues that managers are being asked to fully oversee millions of transactions involving billions of dollars, and that it cannot be assumed that good oversight can easily be achieved. She then explains that complex laws, such as the 2,319 page Dodd Frank Act of 2010, are incredibly complicated and contain many loopholes. She also believes that reinstating the 37 page Glass-Steagle Act as a way to avoid financial crises may not be the answer either. She is calling for a comprehensive re-analysis of our past financial crises, in order to identify the steps we need to take in order to make our existing laws and regulations more understandable.She also wants to see measures taken to prevent our financial institutions from gambling with government-insured money.

Specific recommendations cited include:

Moving all derivatives trading onto regulated changes;
Requiring better regulation over the shadow banking sector;
Ending offshore banking tax avoidance practices;
Closing tax loopholes;
Increasing transparency in all financial dealings;
Discouraging investment practices that favor short-termism;
Charging banks fees, when trading stocks, bonds and derivatives;
Requiring banks to be more prudent, by having them put more of their own money into risky deals;
Reminding financiers to be aware that they too will share pain when crises do happen; and,
Holding banks to higher standards by emphasizing the primacy of their role as catalysts to business.

Use of Less Debt and More Equity

Ms.Foroohar makes a compelling case for using less debt and more equity, when trying to stimulate private sector growth. She clearly expresses the view that although increased use of debt (e.g., its credit) can stimulate growth, it has limits. She also argues that large amounts of debt are always a precursor to financial crises and a larger financial sector often means a less stable economy. She then recommends that banks be required to use at least 20 to 30 percent equity when making investments;

She then warns that if the amount of credit being used to stimulate growth rises too quickly, it increases the risk of having a financial crisis that would slow any economic recovery.

She realizes that “goosing” the economy in a safer manner is a challenge, requiring: establishing political consensus for undertaking many of the “fixes” that have been identified; re-educating those in the finance industry who have been engaging in excessive financialization practices; obtaining a consensus from all economic sectors for developing a cohesive national growth strategy that can be sustained without creating bubbles; and, revamping of our tax system that better serves the real economy and bolsters of the social safety net. Another tall order!

She then identifies a number of discrete steps that could be taken to encourage savings and building equity, other than by self-funding.

Mentioned are such measures as:

Modifying regulations and tax credits to encourage banks to lend more to socially useful causes versus engaging in short-term trading transactions;
Allowing debt service payments to be lowered in periods where GDP is temporarily declining; and,
Allowing mortgage rates to downward adjust in times of falling housing prices, so that mortgages do not go upside-down to the degree that property owners decide to default on mortgage payments and walk away from their properties.

Comments: Briefly discussed in recent articles and not specifically addressed in this book are problems that have surfaced as a consequence of allowing consumers easy access to high cost credit especially in the area of credit cards, auto loans and title loans. The excesses that have occurred in this area have contributed to our wealth distribution problems and to a slow economic recovery. The remedies for these excesses point to the lax lending policies of the issuers of consumer credit and the usurous terms under which such credit is being issued. And there are some recent reports that there is now a considerable number of auto loans that have become sub-prime, leading to the formation of a secondary market for bundles of a toxic mix of such loans and their derivatives. This has now reached a point where another bubble is being created which could burst at any time.

Changing The Corporate Mindset of American Business and Finance

This chapter calls for a re-examination of the notion that companies should be run solely (emphasis added) for the benefit of shareholders. As previously explained, Ms. Foroohar believes that this has become a problem because shareholders are “short-term focused” and companies have become “quarterly-results-driven” which is undermining their “long-term viability”. She also believes that this “mindset” has led to companies “jacking up their share prices and cashing out as quickly as possible”. She attributes this cycle to having led to slow economic growth and the proliferation of consumer debt products that financial institutions now offer. She then warns us again that “this will lead to creation of risky financial bubbles that explode on a regular basis that will take us all down with them”.

Her remedies for mitigating this effect include

Imposing regulations to limit the amount and size offshore buybacks;
Raising capital gains taxes using a sliding scale that accounts for how long an asset is held;
Imposing regulations to limit the amount of corporate pay that can be awarded in stock options; and,
Imposing regulations that would require American corporations to include among their board members representatives from their labor force and from civic leaders, not just representatives from their exiting investors and other stake holders.

Building A New Growth Model

Ms. Foroohar concludes that “financialization is both a cause and a symptom of slower growth” and “too much finance hinders growth”. She has also observed that slower growth encourages policy makers to use finance as a quick fix to deep structural problems within our financial system and it is these “quick fixes” that have created global market reverberations that has led us to the dysfunctional cycle of financialization that we now have.

She explains that economic growth of the emerging markets is putting pressure on the US to continue to grow its economy, while at the same time it is creating huge amounts of new wealth for these developing nations that they are now investing into our financial markets. But she concludes that we have not invested these funds wisely, as they had been used by our financial institutions to create new debt bubbles in the US economy, while slowing down long-term investment and economic growth and creating a rising inequality in wealth distribution. She observed that from the 1980’s onward these bubbles had been amplified by deregulation and easy credit and they finally burst in 2008. And as a consequence American companies and American consumers stopped spending and our economic recovery is still lagging. Not good!

In addressing how to break this dysfunctional cycle, Ms. Foroohar calls for regional cooperation in the global economy on part of its major emerging partner players, such as China, Japan Europe and America. She is also calling for the establishment of a “strong economic growth model that would bolster the real economy”. She argues that such a model must have as its primary objective, the creation of substantial gains in productivity and innovation of the real economy, that can never be achieved through short-term financialization. This is indeed a “new moonshot goal for economic growth” (her words, not mine), as it requires a broad consensus among the public and private sectors, among regions and a set of longer term commitments.

On a national scale, she envisions that the US should establish a national green stimulus program where sustainable energy technologies are developed and investments made to obtain material sources of sustainable energy, while generating economic growth. As to Europe, she would like to see members of the EU create a “federalist system” where wealth transfers between rich and poor countries could then be used to create a sustainable growth model for all members. And as to China, Japan, South Korea, Singapore, and Taiwan, she would hope that they all cooperate in making the transition from “a manufacturing driven economy”, to “a more sophisticated service-driven economy that also manufactures in a sustainable manner”. She realizes that China in particular, has to sort out whether its autocracy can coexist with advanced capitalism so it too can avoid financial crises and recessions and achieve a better and more sustainable way to stimulate growth. A tall order indeed!

Changing The Narrative by Empowering “The Makers”

Ms Foroohar wraps up her narrative listing a number of ideas on how to build a healthier market system that put the entire global economy on a better path. She observes that “financialization” of our “market system” by “moneyed interests”, that “enriches only the select few”, can no longer be expected to support sustainable and widely shared economic growth.

The major fundamental changes she foresees as being sorely needed include:

Reigning in of banking sector lobbying;
Making labor relations more productive and less contentious;
Instituting incentive pay reforms;
Closing tax loopholes;
Making market capitalism more transparent and less subject to fraud and abuse;
Changing the mindset of business leaders to modify their financing practices to be more of a ”helpmeet to business”, not just a way to accumulate wealth as “an end in and of itself”.

She then mentions a government agency-the Office of Financial Research in the US Department of Treasury (“The OFR”) that was created after the 2008 crisis “to examine where risks might lurk in the financial system” She claims that “it has already done great work” and recommends that it be given further independence and put outside of the jurisdiction of The Treasury and be used to “further explore ways to avoid financial crises in the future”.

Observation: Although using The OFR in this way sounds like a good idea, the question remains as to whether regulators and the finance industry will take their advise.

Commentary: If one agrees with Ms. Foroohar that most, if not all of prescriptions for “fixing” our financial system are needed, questions remain as to who will take the initiative to see that these fixes are adequately considered or initiated let alone undertaken. Much depends on changes that are needed in the mindset of those decision makers who are involved with the “Makers and Takers” of American business, and with our governmental agencies , our international partners, our politicians, and our voting public.

To bring about such widespread changes in thinking, it will require sustained leadership and cooperation, that I believe is not in-the-cards, unless there is another occurence of some economic catastrophe. But there are a number of suggestions being made that could go a long way to answering the basic question: “ Can We Avoid Another Cataclysmic Meltdown Of The Global Financial System?”

Ms. Foroohar and others believe such a meltdown is still highly probable READ MORE and MORE (The Washington Post) and MORE (The Nation)